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How Tax Reform May Affect Executive Compensation

Tax reform brought with it notable changes to Internal Revenue Code Section 162(m), the provision that limits the tax deductibility of compensation in excess of $1 million paid to “covered employees.” It also stipulates that CFOs are now automatically covered employees, subject to the revised rules. Elizabeth Drigotas, principal in Deloitte Tax LLP’s Washington National Tax group, and Michael Kesner, principal, Human Capital – Actuarial, Rewards & Analytics, Deloitte Consulting LLP, address some of the ways in which Section 162(m) rules have been modified by tax reform and some potential implications for compensation strategies.

Q: What are some of the more notable takeaways regarding the Section 162(m) revisions?

Elizabeth Drigotas

Elizabeth Drigotas: Essentially the rule states that organizations are now limited to $1 million a year in deductions for compensation paid to each of five people: their CEO, CFO and the three highest-paid officers on the proxy. If someone is paid, for example, $1 million a year in base salary, that is all that the organization can deduct.

Setting aside the transition relief provided, once the $1 million limit per covered employee is reached, performance bonuses, options, equity, deferred compensation are no longer deductible. And once an executive falls into this category, this rule applies to the executive forever. So even if an organization tries to stretch compensation throughout the life expectancy of an executive who has left the organization, the $1 million per year limit remains. There’s not much to be done to get this deduction back.

Elizabeth Drigotas: The language of the statute structured the rule originally to apply to the CEO and the four highest-paid executives as disclosed on an organization’s proxy. That often included the CFO, but not always. In 2006 the SEC modified its disclosure requirements to apply to the PEO/CEO, the PFO/CFO and the three highest-paid employees. But that meant that the language in Section 162(m) and the SEC regulations didn’t align, so according to guidance issued by the IRS to reconcile the two rules, CFOs were not automatically covered employees. Now they are. In fact, if a CFO is the “principal financial officer” for any portion of the taxable year, he or she is considered a covered employee.

Q: How might the fact that CFOs will be “covered employees” under the new tax rules impact compensation negotiations and contracts going forward?

Michael Kesner

Michael Kesner: It’s too soon to tell. Core compensation plans for all executives, not just the CFO, are unlikely to change, but there are things to consider. As one example, options became a staple of compensation packages in part because of tax deductibility. Now that option gains are no longer exempt from the $1 million cap it is possible companies will revisit their option granting strategy. Shareholders, the investor community and corporate governance advocates have continued to emphasize pay-for-performance, and that is unlikely to change due to revisions to the tax law.

As a second example, payments to exiting executives were fully tax deductible under the previous Section 162(m) rule, as it only applied to the named executive officers who were employed on the last day of the taxable year in which the deduction was being claimed. Under the new rule, severance payments, the accelerated vesting of equity and distribution of deferred compensation are subject to the deduction limitation. This could have the effect of reducing the amount of severance or willingness of the compensation committee to accelerate the vesting of equity awards for terminating executives, and might also lead to installment payments that attempt to minimize the impact of the $1 million cap.

Q: What are some misperceptions or misunderstandings about the impact of tax reform on compensation plans?

Michael Kesner: Several myths have already cropped up regarding the potential impact of the changes to Section 162(m). One is that the lifting of the performance exemption under Section 162(m) will prompt more companies to increase base salaries above $1 million. In fact, many companies already have base salaries that exceed that amount, due to market competitiveness. Tax deductibility has not been a driving factor in setting base salaries up until now and the new rules are unlikely to cause a shift.

A second myth is that companies will de-emphasize performance shares and stock options in favor of restricted stock units (RSUs). As previously mentioned, institutional shareholder pressure for more performance-based pay makes this unlikely. That said, there has already been a big move away from stock options due to compensation uncertainty and their lack of retention or holding power. For those reasons some option values may shift to RSUs.

Q: Do the new Section 162(m) rules pose income tax accounting issues that CFOs and their tax teams should take note of?

Elizabeth Drigotas: Yes, the fact that accounting and tax take some of these compensation arrangements into account at different times could pose issues. For example, with nonqualified stock options, book compensation expense is recognized over the service period, but the tax deduction is at exercise, the same time as when the individual has compensation income. As book compensation expense is recorded, a deferred tax asset (DTA) is generally recognized if the income tax regulations allow a tax deduction in the future. Previously, companies may not have had much of an issue with this process because, in most cases, they believed their plan would qualify for a deduction. Under the new law, companies will have to work through the implications of the transition rules to determine if previously recorded DTAs will be affected. Similarly, as new compensation expense is recognized, companies will need to determine the appropriate accounting treatment and leading practices will emerge.

Michael Kesner: There is a transition rule that provides payments made pursuant to a “written, binding contract” in effect on or before November 2, 2017, can still be deducted. But there is no clear guidance on what contracts or agreements fit within that definition. It is almost universal for plans to be worded in a way that gives the compensation committee the right to use discretion in determining final payouts. For example, some companies create a bonus pool and then make various adjustments and judgments that influence how large a bonus an individual receives in any given year, while others have very formulaic plans but rely on compensation committee discretion as a safety valve, to be acted on only if something unforeseen happens. Either way, the fact that many bonus plans acknowledge a level of discretion raises the question of just how binding such agreements are, and therefore whether the transition rule applies.

Q: Is there a chance that the Section 162(m) rule changes could affect companies that may be trying to attract people from overseas?

Michael Kesner: This is a disallowance for a U.S. tax deduction only, so keeping an executive located outside the U.S. at his or her current location may reduce the lost tax deduction. Based on experience, however, those types of decisions are usually not based on the tax efficiency of the executive’s pay, but on what makes the most sense from an operating model perspective.

Q: Will this change affect some companies more than others?

Elizabeth Drigotas: Companies that are acquisitive may face two issues. First, if a company buys a target subject to Section 162(m) and that acquired entity therefore has a “short tax year” prior to the change in control, severance and cash-outs and other forms of compensation will now be subject to the $1 million deduction limit, which was not the case under the old law. Second, under the new law, the acquiring company’s covered employees include the covered employees of predecessor entities, so the acquirer potentially has more covered employees.

That list of covered employees can grow in another way, as well: Companies going through a period of uncertainty in which they hire, for example, CEOs who serve short tenures and are then replaced may find that the tax implications of those salaries, bonuses, golden parachutes and so on start to add up.

Another issue that could affect some companies more than others involves organizations where the list of highest-paid officers changes. At many companies, the executives listed on the ‘comp table’ change year to year as different divisions or business lines do better or worse. Under the new law, once you make the list, your deductible compensation is limited forever.

Q: What are some steps CFOs can take to address these issues?

Elizabeth Drigotas: There are several steps CFOs can take: First, review the population of current and potential covered employees and identify and review existing contracts and agreements to see which ones may be covered by transition relief. This will be important in considering how the new law might impact existing and future DTAs. Second, given the uncertainty around the scope of transition—for example, the issue around discretion noted earlier—it will be important to be deliberate before deciding to materially modify an agreement that might be eligible for transition.

Q: When designing new incentive plans, what are some of the design features companies should consider?

Michael Kesner: Generally, companies will be able to build in more flexibility in determining earned incentive awards and simplify incentive plan administration if they have been using Section 162(m) qualified plans.

For example, many companies shied away from using individual performance modifiers because a subjective assessment of individual performance did not meet the performance exemption requirements of Section 162(m), unless it was used to reduce pay. There was also a risk that the use of an individual performance modifier could taint the entire incentive payout. Going forward, more companies may want to consider including an individual performance factor in the incentive plan, which would allow the compensation committee to increase or decrease incentive payouts based on an assessment of the executive’s individual performance. However, to help avoid shareholder and proxy firm criticism, companies will likely keep the individual component at 20% or less of the target bonus. Plus, companies should keep in mind that the SEC requires the individual goals and performance assessment be disclosed in the CD&A, which could deter some companies from considering whether to add an individual performance component at all.

Companies can also remove or revise individual award limits contained in incentive plans—other than the total number of incentive stock option shares that may be issued, as that requirement stems from Section 422. They can also expand who is eligible to serve on the compensation committee, as Section 162(m) limited participation to “outside directors” as opposed to the SEC and stock exchange rules, which require “independent directors.” The big difference is that a former officer of the company could never be considered an outside director, even in cases where a member of the board of directors became interim CEO for a short period of time, and then reverted back to being a board member once a new CEO was hired.

Other simplification measures include removing the requirement that shareholders approve performance metrics and eligibility criteria, deleting the list of performance metrics and permitting adjustment of performance goals during or after a performance period. Companies and their compensation committees also could remove the requirement that performance goals be set within the first 90 days/25% of a performance period.

Q: How are some organizations addressing the impact of lower tax rates on performance-based compensation?

Michael Kesner: Many companies already have increased their 2018 annual incentive plan targets and 2018 to 2020 performance cycle goals to reflect lower taxes. For instance, some companies are using a “constant tax rate assumption” for incentive plan purposes, as they have not had time to properly estimate their 2018 effective tax rate or the tax rate that might apply for the 2018 to 2020 performance cycle. That’s likely because they have not determined the full impact of tax reform as well as the impact of related tax planning they will employ in response to some of the tax law changes. The benefit or detriment of actual taxes below or above the constant tax rate assumption will be eliminated from the incentive plan calculation in these situations. However, if the organization uses pre-tax measures like revenue, EBITDA (earnings before interest, taxes, depreciation and amortization) or EBIT (earnings before interest and taxes) there may not be a need to make any adjustments.

Often plans provide for adjustments to performance metrics or reported earnings used in incentive plan calculations in the event of certain unplanned or unforeseen events, and such adjustments often include a change in tax law or U.S. GAAP. In 2017, a number of companies recorded losses in the fourth quarter due to changes in the tax law and lease accounting, for which executives and employees likely will receive some tax relief when calculating 2017 annual bonus and performance awards that cover 2015 to 2017. It is equally likely—and a way to preserve symmetry—that the benefit that flows through the P&L from lower taxes will be adjusted out of earnings and used in calculating incentives for open, long-term incentive plan performance cycles, including the 2016 to 2018 and 2017 to 2019 incentive cycles.

Q: How might organizations respond as they work through adjustments of compensation metrics?

Michael Kesner: For those plans that do not require adjustments under the terms of the plan, it is likely the compensation committee will use its discretion and make equitable adjustments. However, there are a number of potential issues that need to be considered. For instance, a discretionary adjustment could be considered a modification for accounting purposes, which would trigger a new measurement date. But this adjustment would apply to performance shares, not the annual cash bonus. Further, the exercise of discretion could break the grandfather rule under revised Section 162(m), which preserves tax deductibility for performance awards granted on or before November 2, 2017. In addition, the change would need to be disclosed in the proxy if it affects amounts paid to the named executive officers, and the proxy advisory firms; some shareholders could have an adverse reaction to changes that benefit executives. Ameliorating shareholder concerns is one reason organizations may want to create symmetry regarding the flow of the benefit.

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